What the attacks in Saudi Arabia mean for oil markets

As trade war uncertainties began hurting global growth over the past few months, oil markets have been focusing mainly on the aspect of demand. However, last weekend’s attacks on two of Saudi Arabia’s largest crude oil facilities have revived the threat of a supply-driven oil-price shock. The attacks have temporarily halted half of the kingdom’s daily production. Given the available buffers (spare capacity, inventories, strategic reserves, and ultimately a call on US shale), our analysis shows that a further price rally would remain limited even if the outage proves more persistent. The medium-term dynamics have not been affected by last weekend’s events; we thus maintain our 12-month target at USD 60/bbl (Brent). Yet, one should expect increased volatility in the short term as the physical market appears more vulnerable to further disruptions until year-end, when KSA will have recovered its full spare capacity.

In a context of a trade-related slowdown, the last thing global growth needs is an oil supply shock. The recent price action, while dramatic in its magnitude, has merely taken oil prices back to their July levels. In other words, if the shock proves short-lived, we should not expect a major impact on global growth and financial assets in general. Only an enduring geopolitical crisis – involving military actions and triggering a closure of the Strait of Hormuz – could support prices above USD 75/bbl (Brent), and would start threatening the current economic and financial environment. This remains a tail-risk to our baseline scenario today.

Attacks in Saudi Arabia: Where we stand

Last weekend’s attacks halved the kingdom’s daily production (the Kingdom of Saudi Arabia produced 9.8 million barrels per day/mbd in August alone). This represents the worst-ever sudden disruption to global oil supplies, with 5.7 mbd affected, or roughly 5% of global output. Moreover, the assets targeted are critical to Saudi’s crude oil production: Abqaiq is used to prepare 70% of Saudi Arabia’s production mainly for export, while gigantic Khurais is one of the world’s largest fields. Prices reacted accordingly on Monday 16 September 2019, posting their biggest-ever single-day advance (USD 9/bbl, almost +15%, see chart 1) on fears of prolonged supply disruption. National oil company Saudi Aramco has already restored 2 mbd of production, and aims to restore August output by month-end, and the company declared it would be able to rebuild its (unverified) production capacity of 12 mbd before year-end (chart 2). If Saudi Aramco does succeed in repairing its production capacity so quickly, then the markets will have avoided a worst-case scenario.

No risk of shortage as inventories will be drawn first, then Strategic Petroleum Reserve if necessary…

The risk of a long-lasting oil shock has dropped significantly in view of Saudi Aramco’s update, and oil prices have eventually stabilised USD 4/bbl above the pre-attack levels. The event will have no impact on the physical market, as Saudi commercial inventories (close to 200 mn bbls) will be used to meet customer commitments until production capacity recovers to August levels. In addition, sizable buffers are available to limit the impact of these outages. Inventories outside KSA can be used as well. After the cuts implemented by OPEC+ late last year, OECD crude and main product inventories are today slightly below their 5-year average, but nonetheless represent more than 60 days of demand coverage (chart 3). It is worth highlighting that thanks to the ramp-up of the US shale industry in 2011-2014 and the oversupply that followed, the current level of commercial inventories is above those in previous episodes of disruption.

Also, most consuming countries maintain a Strategic Petroleum Reserve (SPR) to counter this kind of situation and to avert 1970’s-style oil shock damage to the economy. The US created in 1975 the world’s largest oil reserve, which currently holds nearly 645 million barrels of oil, according to the US Department of Energy. The reserve has been used only three times, most recently in June 2011 when President Obama directed the sale of 30 million barrels of crude oil to offset supply disruptions due to unrest in Libya. The release of these stocks is usually coordinated by the International Energy Agency (IEA), but is triggered generally after oil prices rally sharply and stabilise at levels likely to weigh on demand and global growth (+20% in 2011). Following last weekend’s attacks, the US administration mentioned it would use the SPR rapidly if needed. Therefore, the likelihood of an enduring supply-driven oil shock as experienced in the 70’s is very low, in our view. Prices are capped by these buffers around USD 75-80/bbl (Brent), levels that should trigger action by the IEA, if history is any guide.

…But the oil market remains at risk of further disruptions until Saudi spare capacity fully recovers

OPEC likes to define itself as the central bank of the oil market, providing or withdrawing liquidity when needed to dampen price volatility.

In March 2011, when war in Libya disrupted 1.5 mbd of supply for more than six months, oil prices jumped by more than 20% (+USD 10/bbl over the month). It took OPEC three months to offset these losses, but we highlight that Saudi Arabia contributed the most to the recovery (chart 4).

Until last weekend, KSA was pumping 9.8 mbd, down from a recent peak of 11.1 mbd before the implementation of cuts, leaving theoretically 1.3 mbd of usable spare capacity that is temporarily unavailable. Today, the ongoing OPEC+ production cuts leave room for other producers to increase output rapidly. A return to the production highs of November 2018 would represent roughly 0.8 mbd of incremental production from Russia, UAE, and Kuwait. As Saudi Arabia is the organisation’s biggest oil producer and its de facto leader, OPEC’s leeway is significantly reduced until the country recovers its full production capacity.

No change in our baseline scenario, but short-term risk skewed to the upside

Over the past few days, the volatility in oil markets reflected not only the unprecedented nature of the attacks, but also the lack of official communication from Saudi Arabia during the first 48 hours.  This has been addressed, and the market now has a clear timeline to evaluate how the repairs are progressing. If Saudi Aramco delivers on its timeline – a crucial point market participants will closely monitor – then the impact on our supply/demand model and inventories in particular will remain contained.

In our baseline scenario, Brent is expected to trade around USD 60/bbl as demand will be affected by global trade uncertainties. Indeed, we revised our 12-month forecast for Brent lower this summer to acknowledge the global economic slowdown and its consequences in terms of demand this year and next (chart 5). This would require further action from OPEC/Russia to limit the anticipated oversupply (discussions about new production cuts will top the next OPEC meeting agenda).

In our baseline scenario, Brent is expected to trade around USD 60/bbl.

US shale producers are unlikely to react to the current price action as the 1- and 2-year WTI futures have not moved dramatically following the attack (around USD 53-54/bbl, WTI). Indeed, futures prices remain below levels considered attractive to start hedging additional production (WTI at USD 60/bbl) or financing new investments in drilling and completion. Should US shale producers need to fill a supply gap (with typically a 6-12 month lag), incremental production growth of 1 mbd would require 1- and 2-year futures to settle at least USD 10/bbl higher (around USD 65/bbl). We thus make no change to our base-case scenario and assume US shale will grow oil production by 0.7 mbd in 2020e.

Whatever the developments in terms of fundamentals, a geopolitical risk premium (of around USD 5-10/bbl) is likely here to stay at least in the short term, as these events represent a sharp escalation in the Middle East tensions. Although Yemeni rebels claimed to be behind the attacks, it is unlikely these could have taken place without the support of Iran, which explains the response of Saudi Arabia and the US. Hopes that the August G7 summit and the departure of US National Security Adviser John Bolton in early September would ease tensions between the US and Iran are clearly fading, and the risk of heightened conflict in the region has increased. Ultimately, Iran could once again ramp up its threats to close the Strait of Hormuz, which carries one fifth of the world’s traded oil.

Even if the medium-term dynamics have not been affected by last weekend’s events, one should expect increased volatility in the short term as the physical market appears more vulnerable to further disruptions until year-end, when KSA will have recovered its full spare capacity.

What if…? Framing the worst-case scenario

As mentioned above, supply shocks should prove short-lived as we would expect a large destocking or the release of SPR inventories to balance the market and cap prices. Only a long-lasting geopolitical crisis, involving military action and triggering a closure of the Strait of Hormuz for a prolonged period, could support prices above USD 75/bbl (Brent), de facto imposing a tax on businesses and consumers – the only resilient segments of our economies, and already penalised by the external shock from trade.

In such an environment, equity indices are likely to suffer from risk aversion at a time when the earnings outlook is already depressed by the global trade situation. A weakening of US consumption would clearly trigger an earnings recession. Even if there could be winners (oil exporters) and losers within the emerging market world, emerging market assets would suffer the most given their high sensitivity to global growth. US high yield might benefit in relative terms (US high-yield issuers still have around 15% exposure to shale oil producers).

Short-term inflation expectations might be underpinned in this environment, but prospects of a deterioration of the economic outlook would mitigate this and eventually send yields to new historical lows. Note that in this context, central banks would certainly not react to the rebound in inflation, even above their targets, and would focus on limiting the downside risk to growth.

In currencies, a sustainable rise in oil prices combined with the decelerating global economy should lead to an appreciation of the US dollar (safe haven) against high-beta, cyclically-sensitive currencies, especially those that are net oil importers (such as INR and TRY). Surprisingly, gold has not reacted to the news this week, but it would definitely attract substantial inflows (increased by the lack of traditional safe-haven assets in the current low yield environment) if current events were to lead to a wider conflict.